Controversial share buybacks funded by debt not only boost share price in the short-term but boost performance in the long term, according to research from two UK business schools.
Share buybacks have become a popular option for companies with excess cash over the past decade, persuading a growing number of firms to borrowing money to repurchase shares. Those whose share price is low are looking to increase debt on their balance sheet to reduce their tax bill and are taking advantage of low interest rates to conduct leveraged buybacks.
This has sparked concern about the rising level of corporate debt in share buybacks, but a study of all the leveraged buybacks issued in the US by Chendi Zhang of Warwick Business School and Zicheng Lei of Surrey Business School found that when companies had low debt levels it boosted performance in the long term.
“It had been thought that using debt in share repurchases is bad for economic growth in the long-run as it harms future investment,” said Dr Zhang. “But we provide evidence that it is not true. We found that, on average, leveraged buybacks benefit shareholders, they create value.
“In the short-run, we found an increase in share price, as leverage buybacks are seen as a signal of a firm being confident about its future performance and also in the long-term – the next one to three years – we found stock performance improves. This is consistent with the leveraged optimisation hypothesis.
“Indeed, we found that when firms’ debt level is too low then they benefit the most from leveraged buybacks, and firms can use this to optimise their capital structure.”
The study, Leveraged Buybacks published in Journal of Corporate Finance, analysed the performance of up to 300 US companies that had repurchased shares through debt. It found that for companies with too much debt, leveraged buybacks harmed the firm’s capabilities.
Dr Zhang added: “In more extreme cases, 20% of the firms we looked at, who already have too much debt, the long-run performance is much worse. But on average we found it benefited company shareholders. The main advantage of debt in the current environment is that it is tax deductible, so you can reduce your tax bill.
“Other benefits that have been found are ‘agency costs’, where leveraging up acts as a motivation for executives as they work harder to pay off the debt, plus it is another signal that you are confident about the future by taking on more debt.”
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